Fashion Designer Denied Research Credits

As it turns out, fashion design will not usually constitute qualified research for the purposes of qualifying for the research credit under Section 41 of the Internal Revenue Code. In a recent case from the Tax Court, taxpayer, Leon Max, failed to convince a sympathetic court that expenses related to his fashion design process should entitle him to the research credits which he claimed.[1]

Background

History of Max and LMI

Leon Max, a Soviet immigrant, came to the United States at the age of 18 to pursue his dreams of fashion design. First arriving and attending school in New York City, then moving to Los Angeles where he began his successful career. Leon eventually started his own fashion design business, Leon Max, Inc. (LMI). Max, together with his business partner at the time, though not mentioned elsewhere in the opinion, purchased a warehouse filled with undyed poplin used in manufacturing typewriter ribbons. Max used this poplin to create a small line of six pieces. The width of the poplin limited the sizes which Max could produce as well. Max, opted to design, make, and sell jumpsuits, a product with no market at the time. These jumpsuits were produced only in small sizes. LMI sold 40,000 of the jumpsuits, netting over $1 million in its first year in business. The growth continued over the years until 2011 and 2012, the years at issue.

In 2011 and 2012, Max was the sole shareholder, CEO, and creative director of LMI, an association taxable as an S corporation. LMI was producing and selling 800,000 to 1 million pieces each month. LMI had lines for some of the typical mall stores such as Macy’s, Belk, Dillards, and the like. The flagship brand however was the Leon Max brand. The Leon Max brand offered Max more flexibility in the design of the garments and allowed for more creative discretion.

The Design Process

LMI maintained and followed a structured process for its garment design, producing a new collection each month for each of its lines. These phases were broken down into broad conceptual planning, design concept and sketch, first pattern preparation, pattern cutting, first sample production, model fitting, sales samples, production prototyping, marking and grading, and preparing a production approval sample.

In the pre-production and design process, LMI would address, among other items, lining and thread issues for finished garments, shifting to plus-size garments, fabric patterns, draping consistency, and design element concerns.

Next, LMI would undertake quality assurance testing and would address trade group, quality, and regulatory compliance. Following testing methods and procedures from groups such as the American Society of Testing & Materials, American Association of Textile Chemists & Colorists, the Federal Trade Commission (FTC), and the Consumer Product Safety Commission, LMI would subject its newly proposed products coming out of the pre-production design process to a battery of tests, including care labeling tests (laundry), colorfastness tests, strength tests, and safety tests. Meeting all company standards was required prior to shipment.

Other Design-Related Items

LMI devoted considerable efforts and resources towards acquiring quality textile materials, requiring Max to attend approximately six textile fairs per year. Occasionally LMI would design its own prints and commission printing on raw fabric. LMI did not manufacture any of its own fabrics directly in the 2011 and 2012 tax years at issue.

The Credits

In 2013, LMI engaged Alliantgroup, a tax consulting firm (Alliant). Alliant conducted a study of LMI over the 2009-2012 tax years to uncover whether LMI would qualify for tax credits. The study was delivered to LMI in 2014. Examining 35 garments from 2009-2012, interviewing LMI employees, reviewing design sketches, prototype photos, spec sheets, emails, and financials, Alliant concluded that 32 of the 35 projects included activities which qualified for the research and experimentation tax credit. LMI claimed $426,255 of research credits on an amended income tax return, Form 1120S, for 2011. Max’s personal return for that year was also amended. LMI also claimed $496,462 in research credits in 2012 by filing an amended return. Max amended his personal return for 2012 as well, claiming $322,700 in credits.

Relevant Law

Section 41 allows taxpayers to take a credit for increasing research activities. The credit is 20% of the excess of a taxpayer’s qualified research expenses for the taxable year over the base amount.[2] Qualified research expenses are (i) in-house research expenses including wages for employees working on qualified research and costs paid or incurred for supplies for qualified research, and (ii) contract research expenses.

To be qualified research, the research must relate to a new or improved function, performance, reliability, or quality of the product of process. Certain activities are excluded, including research after commercial production, adaptation or duplication of an existing business component, market research, testing, or development, or routine or ordinary testing or inspection for quality control.[3]

Further, to be “qualified” the research must satisfy a battery of the following four tests:

The Section 174 Test

This test requires that research expenditures be eligible for treatment as an expense under Section 174, which generally allows taxpayers to deduct research and experimental expenditures during a taxable year in which such expenses are paid or incurred. The associated regulations define research and experimental expenditures as “expenditures incurred in connection with a taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”[4] Such costs in the experimental or laboratory sense are “activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.”

Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.[5] The resolution of uncertainty however, does not necessarily require experimentation.[6]

Max argued that LMI faced uncertainties throughout the development process noting issues relating to: how to cut and drape printed fabrics; fabric choices; thread sizes; details such as twists, pintucks, and pleating; modifying patterns for plus-size garments; fabric shrinkage, and final fit of the garments. The Tax Court stated that those issues were not “uncertainties” as contemplated in Section 174. These items were well known and understood by designers and patternmakers. Specifically, Section 174 was to “limit deductions to those expenditures of an investigative nature” used to “develop[] the concept of a model or product.”[7] The Court distinguished LMI’s expenses as being related to “actual construction” and not being of an investigative nature. Citing Merriam Webster, the Court elaborated on the term “investigate” in coming to its conclusion. To investigate would be “to observe or study by close examination and systematic inquiry.” Therefore, to be “investigative in nature,” the Court concluded that LMI would have been required to examine an uncertainty at issue and systematically inquire after potential solutions to resolve the issue.

In the end, LMI’s studies were not investigative in nature and were not research in the sense contemplated under Section 174. The Court specifically struggled to reconcile how test fitting garments on models was investigative in nature. Further, many of the uncertainties listed by Max could be addressed by trial and error or a simple question/answer session with a model. The business, it seemed, already knew how to arrive at the answers and, each alleged uncertainty taken alone, did not require a systematic process to uncover the answers sought.

Citing to Union Carbide Corp. & Subs v. Comm’r, 97 T.C.M. (CCH) at 1255, the Court noted a taxpayer did not have an uncertainty under Section 174 when it ran a machine at 5,000 RPMs because it previously tested the machine at 5,000 RPM, and thus knew the consequences of doing so.

The Technological Information Test

To be “qualified research” an activity must be undertaken for the purpose of discovering information that is “technological in nature.” Information is “technological in nature” if “the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.”[8] Max argued that LMI fundamentally relied on science and engineering in its production process, claiming that fit testing relies upon engineering, fabric draping and fabric print alignment relies upon material sciences, and fabric shrinkage and colorfastness tests rely on chemistry. The Court disagreed, citing Merriam-Webster once again to address basic definitions. In short, “does it fit” and “does it look right” was a matter of trial and error, practice, and eyesight, not engineering and material science.

The Process of Experimentation Test

The process of experimentation test requires that substantially all of the research activities constitute elements of a process of experimentation for a qualified purpose. The three elements of the test are (1) the substantially all element, (2) the process of experimentation element, and (3) the qualified purpose element.

Addressing the elements in reverse the Court began with the qualified purpose element. Purpose is not qualified if it relates to style, taste, cosmetic, or seasonal design factors.[9] Unfortunately, notwithstanding arguments made to the contrary, the purposes were not qualified as they fell almost entirely into the non-qualified purposes specifically mentioned.

As to the process of experimentation element, the Court held that LMI did not establish that it followed a process of experimentation, being a “process designed to evaluate one or more alternatives to achieve a result” when the taxpayer is uncertain at the beginning of its research activities of the capability or method of achieving the result or its appropriate design. Uncertainty in the process of experimentation “is essentially the same uncertainty as required by the [S]ection 174 test.”[10] Hard sciences must be used to achieve a business’ goal. The regulations state that the “process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.”[11] Further, the process of experimentation requires taxpayers to use a formalized scientific method to address uncertainties.[12] Merely taking steps to improve a business component does not necessarily constitute a process of experimentation, and the Court noted that the project must use a scientific method involving a “methodical plan involving a series of trials to test a hypothesis, analyze data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.” LMI did not employ a process akin to the scientific method to address issues, but the Court noted that LMI’s pre-production process required care and diligence to create garments. But notwithstanding how thorough or methodical LMI’s process was, it was not true experimentation in the scientific or laboratory sense.

The substantially all element also was not satisfied in the Court’s opinion. To satisfy the test, at least 80% of the taxpayer’s research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose.[13] Many of LMI’s activities were related to style, taste, and seasonal design factors. Therefore, those activities were not qualified. In the end, LMI did not prove that substantially all of the garments underwent a process of experimentation.

The Business Component Test

The business component test requires that research undertaken to discover information must be intended to be used to develop “a new or improved business component of the taxpayer.”[14] A business component is “any product, process, computer software, technique, formula, or invention which is held for sale, lease, or license, or used by the taxpayer in its trade or business.[15] The Court dispensed with its discussion on this test as LMI failed the prior tests.

Conclusion

Unfortunately, it the taxpayer, to whom the Court shows some sympathy, did not prevail on his arguments. It is worth noting again that the Tax Court is not a court of equity. Just because a taxpayer’s efforts are substantial and are follow a similar pattern to qualifying activities for certain tests and elements, qualification is a matter of substance and sympathy and/or equity are not sufficient to result in relief. While Max seems to be a great businessman enjoying incredible success in his industry, his consistent and rigorous processes, research, and testing, will not qualify him for credits under Section 41 if the activities fail to objectively qualify under the tax law. Also, it would seem the research credits are reserved for businesses researching, experimenting, and employing hard sciences in their product and process developments.

[1] Max v. Comm’r, T.C. Memo 2021-37.

[2] IRC § 41(a)(1).

[3] IRC § 41(d)(4).

[4] Treas. Reg. § 1.174-2(a)(1).

[5] Id.

[6] See Little Sandy Coal Co. v. Comm’r, T.C. Memo 2021-15, at *36.

[7] See Mayrath v. Comm’r, 41 T.C. 582, 590 (1964), aff’d, 357 F.2d 209 (5th Cir. 1966).

[8] Treas. Reg. § 1.41-4(a)(4).

[9] IRC § 41(d)(3)(B).

[10] Union Carbide Corp. & Subs. v. Comm’r, 97 T.C.M. (CCH) at 1256.

[11] Treas. Reg. § 1.41-4(a)(5)(i).

[12] Id.

[13] Union Carbide Corp. & Subs. v. Comm’r, 97 T.C.M. (CCH) at 1255 and Treas. Reg. § 1.41-4(a)(6)

[14] IRC § 41(d)(1)(B)(ii).

[15] IRC § 41(d)(2)(B).